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How to Trade a Range-Bound Market

How to Trade a Range-Bound Market

 

Most traders agree that a trending market is easier to trade than a range-bound market.

Once you hop aboard a trend, you pretty much just have to trail a stop and ride the gains. Sure you deal with plenty of whipsaws and failed pullbacks, but there are far fewer variables in a trending market than a range-bound market. 

You might ask why one would even bother trading range-bound markets if trend trading is easier for them. And that’s a legitimate question.

Many very successful traders stay away from range-bound trading altogether.

But markets are only in a trending state a minority of the time, meaning you might be forced to sit out of some of your favorite markets for extended periods of time if you only have a green light to trade when there’s a trend. 

The thing I like about trends is they’re kind of ‘face-up.’ There are simple factors that indicate roughly how likely the trend is to continue, fail, or simply peter out.

These are things like the nature of the pullbacks, how each swing in the trend compares to each other, and if momentum is declining or holding steady. 

Furthermore, identifying a trend is easy.

It’s a series of consecutive higher highs and higher lows (vice versa for downtrends). As soon as the market stops obeying that definition, it’s no longer trending.

You can basically categorize all other price action that doesn’t meet the definition of a trend into the ‘range-bound’ category. 

Ranges can be quite random.

While you can typically draw a box around the recent price action of a range, you’re doing that with the benefit of hindsight. It’s hard to redraw the box with any reliability as price action unfolds. 

Ranges are characterized by relative agreement by traders about where the price should be today. Buyers and sellers are relatively equal in number and aggression, and neither side has enough conviction to move the price beyond the range.

On the other hand, ranges present an indecisiveness about the future.

The market has yet to decide where it’ll go in the future when it breaks out of the range and starts trending.

Why To Consider Range-Bound Trading

I’ve spent the first portion of this article explaining why trading range-bound markets isn’t for everyone: it’s far less straightforward than trending markets and there’s more random price action. 

However, markets spend most of the time in ranges, meaning you dramatically increase your trade frequency if you add in some range-bound strategies to your toolbox.

The obvious caveat here is that increasing your trade frequency is only positive if you have a positive expected value, which takes time when devising new strategies in an unfamiliar market regime like a range. 

Furthermore, you might find you prefer to trade ranges. Just because most traders like trends doesn’t mean you will. 

Lastly, even if you’re primarily a trend trader and would like to remain that way, experimenting with range-bound trading will teach you a lot about the nuances of range-bound price action, which is likely to lead to insights about how ranges become trends.

The Key Factor for Range-Bound Trading

There are tons of nuances to trading ranges.

But this is a relatively short article and we’re going to stick to core concepts from which you can build a base to start trading ranges and learn those nuances yourself. 

Just as there’s plenty of nuance to trend trading, but the core concepts of swing analysis, momentum convergence/divergence, and pullback behavior are the primary concepts that will drive most of your results.

We should be applying the 80/20 Rule to our learning processes, meaning spending your time on the 20% of factors that drive 80% of results, while learning the rest through osmosis. 

The key factor in range-bound trading is the price action that occurs around support and resistance levels. In your analysis, you’ll be looking for either price rejection or price acceptance.

Price rejection broadly refers to when the market makes it very clear that it cannot support the previous prices. This is most often characterized by a multi-standard deviation move against a price level.

For example, let’s say a stock is bouncing between the support and resistance levels of $8 and $10, with an average daily range of $0.25.

The stock briefly touches $10, only to make a rapid $0.75 decline in price. This is textbook price rejection.

The market did not have the support to maintain a price of $10, and traders realized this all at once, pushing the price down multiple times the average daily range. 

Price acceptance is the opposite of price rejection, when the market is accepting of the current price. Taking the previous example, imagine the stock reached that same $10 level, but meandered around there for several days.

The market’s lack of conviction to move the market away from that level shows a lack of resistance there, indicating a likelihood that this $10 resistance level will break.

In short, price rejection is when price moves sharply against a level, like when a stock briefly touches a resistance level only to decline. Price acceptance is when the market accepts the price at a significant level, like when a stock meanders around a significant resistance level. 

So, as you can see, range-bound trading isn’t simply about buying at support and shorting at resistance. It’s instead about analyzing the character of the price action around those levels, and trading accordingly.

Strategies for Trading a Range-Bound Market

Trade setups are a dime a dozen, and they all are slightly altered methods of capitalizing on the same few trading phenomena.

There’s a million trend pullback setups, some using ADX, others MACD, and others using pure price action. But they’re all trying to buy a trending stock during momentary counter-trend weakness.

The same is true of range-bound trade setups.

Everyone has their own levels they ascribe some importance to, and certain parameters a stock has to meet to be tradable, but they’re all trying to fade a stock that deviates from its range, or play a range expansion like a breakout setup. 

So with that said, we’re going to look at one simple trade setup to capitalize on range-bound markets: the breakout trade.

While there are several different setups you could trade in range-bound markets, they take more experience reading range-bound markets, which most readers of this article are unfamiliar with.

Next week, we’re going to review what you might call an “intermediate” setup for taking advantage of range-bound markets: the test-reject, or better known as the Wyckoff “Spring.” 

The Breakout Trade

A breakout is a significant range expansion, leading the price to new recent highs (or lows), often starting a new trend.

You can think of a breakout like Black Friday shopping. On Thanksgiving, Wal-Mart and Best Buy are mostly empty and quiet, and then one day passes and they’re packed out to the point of the local fire department getting involved.

Breakouts often occur in boring, sleepy stocks that the market has forgotten about. Just a small shift in supply or demand can create a huge price move, motivating other traders to get in and chase the trade, which further exacerbates the original effect. 

Perhaps the best technical definition of a breakout trade was written by Jack Schwager in his most recent addition to the Market Wizards series, Unknown Market Wizards: 

“A breakout is a price movement above or below a prior trading range (sideways movement in prices) or consolidation pattern (e.g., triangle, flag, etc.). The underlying concept is that the ability of prices to move beyond a prior trading range or consolidation pattern indicates a potential trend in the direction of the breakout.”

Here’s a quick drawing of the “textbook” breakout pattern you’ll read about in classic technical analysis literature: 

 

At play you have a range-bound stock with reasonably well-respected support and resistance levels, the stock has been within the range for a long while.

Notice on the right edge of the drawing, before the breakout, the stock tests support on significant momentum, only to experience price rejection and the stock breaks out from resistance in the opposite direction. 

Every breakout is different, of course. The above drawing is the most idealized example of a breakout for demonstration’s sake.

Some key factors to look out for when trading breakouts are: 

Well Defined Support and Resistance Levels

If you have to investigate for them, they probably don’t exist.

The idea of support and resistance levels isn’t this ephemeral, metaphysical thing that brings markets into balance when they stretch too far. It’s all based on human behavior.

Buyers prefer to buy at the bottom of the range. Some of them get filled, many don’t. Sometimes, those that don’t get filled get more aggressive and buy above support, which creates momentum, inviting additional buyers to push the price up. 

For this reason, most “real” support and resistance levels are very obvious to anyone who looks at the price chart.

Price Acceptance at Crucial Level

Breakouts are characterized by range contraction right at or near the breakout level, followed by an explosion of range expansion once the break of the level occurs. 

What you’re looking for is for the market to continually test the breakout level without experiencing price rejection. 

The market is telling you that traders are willing to consistently pay prices at the high end of the range, unwilling to take the chance that the stock will fall back towards the middle or bottom of the range.

Range Contraction

Perhaps the most textbook element of a breakout is the tightening of the range (the market is getting ‘bored’) prior to the breakout occurring.

This is the Black Friday idea mentioned earlier, where just prior to Black Friday, the stores are empty and customers have little urgency to buy goods. But once doors open and those sales are in effect on Black Friday, customers rush in to buy anything they can. 

In these scenarios, you witness the market move from a state of equilibrium (range contraction at a price level, indicating momentary ‘agreement’ from the market) to a state of disequilibrium, where volatility and chaos rule. 

Bottom Line

There’s a certain allure to trading range-bound markets to trend traders. You know, the grass is always greener.

When you flip through some technical analysis books, it all looks so simple.

You define the range, buy at support, then sell at a moving average or even at resistance. But if you’ve tried this a few times, you know how tricky trading ranges can actually get because of the randomness involved. 

However, there’s a slew of traders who make their living trading boring, range-bound stocks because of their ability to read between the lines of the price action, as well as read some of the nuances of market psychology, like being able to read the population that typically trades a stock.

Just remember – rangebound markets can be tough to trade due to the randomness but catching a breakout trade from a range can be well worth your patience.